Stock options are an increasingly popular way for companies to compensate employees in a cost-effective manner. Not only can options attract potential employees, they also incentivize employees to work hard so the company’s fair market stock value continues to rise.
Unlike your salary or bonuses, stock options are slightly more complex to understand. While these options can help build wealth as an important part of your compensation package, it’s key to understand what they are, how they work, and to create a plan for exercising and maximizing them.
Types of Stock Options
There are two types of stock options a company might offer: Incentive Stock Options (ISO) or Non-Qualified Stock Options (NQSO). Both types allow you to purchase a certain number of company stock at a predetermined price.
However, there are differences between ISOs and NQSOs. For example, ISOs are only available to employees of a company while NQSOs can be awarded to anyone, including independent contractors. The biggest difference is how the two types of stock options are taxed, which means you should make an appropriate plan for exercising based on the option type you’ve been awarded.
Taxes on Non-Qualified Stock Options (NQSO)
There are two types of taxes when dealing with NQSOs: ordinary income tax and capital gains tax. Ordinary income tax is based on the spread between when you exercise your options and purchase the shares (i.e. the difference between the stock price market value when you exercise them and the strike price). Capital gains tax occurs when the stock shares are sold and is calculated by the difference between the sale price and the stock price when the shares were exercised.
You are granted NQSOs with a strike price (also known as grant or exercise price) of $5. You decide to exercise your options when the stock price is $10. The $5 difference of the price at exercise ($10 minus the strike price of $5) is the spread and is taxed as ordinary income.
When the stock price hits $15 per share, you decide to sell. You will pay capital gains tax on the difference between the price you sold your shares for ($15) and the stock price when you exercised your options ($10).
Taxes on Incentive Stock Options (ISO)
Incentive Stock Options (ISO) are considered more favorable tax-wise. Why? Because you may be able to avoid paying ordinary income tax (the higher of the two tax types) if you exercise the options and hold them for a specific period of time. That specific time is known as the holding period and means you must keep ISOs for one year after exercising the options and two years after the options were granted. However, you may be subject to paying alternative minimum tax (AMT).
You are granted ISOs with a strike price of $5. You exercise your options one year after they were granted when the stock price is $10. The difference between the price at exercise ($10) and the strike price ($5) will be included in the AMT calculation, which means exercising your options may lead to owing AMT.
You hold the stock for another year and sell the shares when the stock price is $15. The entire difference ($10 between the sale price of $15 and the strike price of $5) would be taxed at the more favorable capital gain tax rate.
Remember though, if either of the required holding periods is not met, then the entire difference between sale price and strike price will be taxed at ordinary income tax rates.
You are granted ISOs with a strike price of $5. You exercise your options one year after they were granted when the stock price is $10. Six months later you sell the shares when the stock price is $15. The entire difference ($10 between the sale price of $15 and the strike price of $5) would be taxed at ordinary income tax rates.
Understanding Alternative Minimum Tax
Extra tax that may occur when exercising ISOs is called Alternative Minimum Tax (AMT). AMT is another way of calculating income tax under a different set of rules. The calculation limits certain tax benefits which may mean a higher tax liability. For stock options, AMT comes into play when you exercise your options but don’t sell your shares in the same year the options are exercised. AMT can be significantly higher than expected, however, working with a tax professional can help you avoid surprises.
Exercise Your Stock Options with Confidence
Figuring out what to do with stock options can be stressful! More often than not, employees find the process to be confusing and overwhelming, which can lead to exercising their options without a plan. Although it’s complex, it’s essential to understand so you don’t find yourself owing significantly more in taxes than anticipated. Reach out to an Abacus financial planner who can help you create a clear strategy to explore your options in the most efficient way possible to reach your unique financial goals.
To learn more about employee stock options and how to see if they’re right for you, check out this Work Your Wealth podcast episode.